Friday, May 30, 2014

Buffett on Farms, Real Estate, and Stocks - Part II

A follow up to this post. In the 2013 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett describes two of his small investments -- a Nebraska farm and a New York retail property -- to help illustrate some important investing fundamentals.

This was covered in the previous post.

In the letter, after using the two small investments to illustrate those investing fundamentals, Buffett goes on to say the following:

"There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.

It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse."

Many participants turn what should be an inherent advantage into a disadvantage. Excessive trading is likely to be unproductive or worse. It likely leads to a bunch of unforced and costly errors.

The result? A less favorable balance between risk and reward for a whole lot time and energy not well spent.

What Buffett describes above is a very sensible way to go about the business of investing. It's certainly not complicated nor is it particularly difficult to understand. Yet the noise distracts. The apparent simplicity masks the fact that the job is a whole lot more difficult to do consistently well than it appears. The merits of the approach becomes lost in a sea of opinions, breaking news, economic reports, and stock quotations.

Psychological factors get in the way.

Compounding effects over a long time horizon -- increases to intrinsic value -- should do the heavy lifting when it comes to generating returns. Yet the incredible low cost convenience of buying and selling in modern equity markets leads some (many?) to a kind of destructive hyperactivity. The equity markets potential strength is converted to a weakness. At least it is for those who choose to trade so often.

I think that Morgan Housel said it very well earlier this year:

"I think the single biggest risk you face as an investor is that you'll try to be a trader. It's the financial equivalent of drunk driving -- recklessness blinded by false confidence. 'Benign neglect, bordering on sloth, remains the hallmark of our investment process,' Warren Buffett once said. It probably should be yours, too."

Sometimes, the biggest challenge is knowing when to -- after doing sensible things around one's own very best ideas -- just get out of the way. Invest in what's sound and understandable. Buy only if attractively priced. Be positioned to act decisively when emotions are running high; when, most likely, the uncertainty or euphoria seem to be at or near its highest. Allow other to lose their composure during the a crisis. Allow others to get caught up in the excitement of seemingly endless and rapid rising prices. Study businesses and learn to judge their long run prospects well. Those prospects may change (or be misjudged), of course, and appropriate action will need to be taken. Serious and permanent damage to the economic moat of a business (i.e. not temporary even if very real difficulties) may warrant action, for example. Extreme overvaluation may warrant action. The opportunity to buy something else that's plainly superior may also warrant action.

All of this is easier said than done.

Otherwise, it generally makes no sense to transact frenetically once something of quality has been bought well in the first place.

Attempts to jump in and out of assets at just the right time is folly.

Such behavior not only adds frictional costs, but likely also increases the chance to that mistakes will be made. When someone buys or sells something in their portfolio, it's naturally done with the idea that it will lead to a favorable result. I mean, pretty much no is going to make a portfolio move unless they expect that move will improve future outcomes. Otherwise, they wouldn't make the move. Yet the evidence suggests just the opposite is likely to happen; it suggests portfolio actions generally reduce returns.

More effort; less reward. That may not be intuitive but, at least, deserves some thoughtful consideration. Some will discount this as just an odd anomaly. Some will choose to ignore it.

That's probably a mistake.

Most participants would benefit from fewer thoughtful moves and by considering how their best ideas are likely to play out over longer time horizons. It's just very easy to be overly confident that each short-term action will result in something fruitful.

I mean, most of us mortals have only so many good ideas. Well, those who are trading all the time seem almost certain to be eventually acting on something that is much further down the list of their best ideas.

Also, frenetic trading means attempting to predict the mostly unpredictable:

That is, near-term price action.

It's important to think of stocks as part ownership of a business because, well, that's of course what they actually happen to be. More from the Berkshire letter:

"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.

It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."

Some will be comfortable judging an individual businesses long-term prospects, estimating its value, deciding on the appropriate margin of safety against that value -- to, at least in part, improve risk versus reward* -- while carefully considering the opportunity costs. If these things are not in one's comfort zone then, well, stay away from stocks.

Some fine low cost index fund alternatives exist and, in any case, it's NOT like most active market participants -- professional or not -- end up doing better than a broad-based index.

Either way, whether stocks or low cost index funds make sense, frequent trading is generally unwise.
(There are, no doubt, exceptions to this but a plan built around being one of the exceptions seems like no plan at all.)

So investing well requires tuning out the noise, an emphasis on reducing errors where possible, and an understanding of how and why certain psychological biases create trouble that can be costly.

Like many things, this naturally also requires a realistic assessment of one's own abilities and limits.

Tuning out the noise means mostly ignoring the near-term quoted prices. The inevitable wild fluctuations will be mostly driven by changes to market participant psychology -- and maybe a build up of leverage that, when prices go the wrong way, results in forced transactions to meet margin calls -- instead of changes to intrinsic business value.

For good businesses -- and even some of less quality -- those quoted price fluctuations will inevitably be much greater than changes to underlying per share value.

Make that an advantage.

Adam

Long position in BRKb established at much lower than recent market prices

* The price paid for an asset can serve to improve risk versus reward but only up to a point. In other words, there are limits to how much a reduced price can be used to manage risks. Sometimes, for example, no price is low enough because the low end of estimated intrinsic business value is too difficult to judge.

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